Central Banks Saved World Economy But Beware the Exit: IMF

Timely central bank intervention helped prevent widespread global economic chaos but their unprecedented and dramatic action could result in potentially heavy losses when they begin to withdraw the extraordinary sums of money they pumped into financial systems around the world, the IMF warned on Thursday.

Timely central bank intervention helped prevent widespread global economic chaos but their unprecedented and dramatic action could result in potentially heavy losses when they begin to withdraw the extraordinary sums of money they pumped into financial systems around the world, the IMF warned on Thursday.

In its most detailed study so far of the dramatic measures taken to counter the damage from the 2007-2009 financial crisis, the IMF said central banks’ efforts bought governments and banks time to enact reforms but central banks face diminishing returns on their balance sheets.

Studying the so-call quantitative easing strategies adopted by the Federal Reserve, Bank of Japan and the Bank of England, the IMF said all three would face balance sheet loses if they had to sell bonds to quickly shrink their balance sheets.

These central banks have pumped trillions of dollars into the global economy through bond-buying campaigns after interest rates were slashed close to zero.

Under a worst-case scenario, the IMF said losses could top 7 percent of GDP for the BOJ, nearly 6 percent for the BOE and more than 4 percent for the Fed, but stressed that the losses would mainly be a political problem and would not hurt the real economy or prevent the central banks from doing their job.

The warning comes as the Fed is increasingly split over how to eventually curtail its asset purchases that have swollen its balance sheet to $3.32 trillion.

Earlier this month, the Federal Open Market Committee agreed to keep buying $85 billion in U.S. treasuries and mortgage bonds a month in an effort to bolster economic growth and reduce unemployment that was 7.5 percent in April.

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But the IMF said central banks had strayed into “unchartered waters” and warned that the eventual exit from unconventional monetary policy could be “difficult to control”.

In particular, long-term interest rates could spike as investors dump bonds deemed overprices and banks could face losses on their portfolios as rates rise. “The market response [to a rise in interest rates] will be less predictable … possibly for several months or even years,” it said.

Urging authorities to stay alert to the risks and “take gradual and predictable measures to address them”, the IMF said:

[quote] Central banks should carefully plan and communicate their exit strategies well in advance to markets, financial institutions, and other central banks to minimise the potential for disruption. [/quote]

Warning of cross-border spill over effects, the IMF also said the loose monetary policies could fuel “excessive appreciation” of emerging market currencies.

Emerging markets have long companied that quantitative easing programmes have led to huge capital inflows, driven up their currencies, threaten their financial stability and made their exports less competitive.

Acknowledging the risks, the IMF however said the effects have weakened and called for greater global policy coordination. “Outcomes could be improved if policymakers in source countries take into account how their policies affect global economic and financial stability. Greater attention to cross-border coordination of policies would also help.”

Related: IMF Warns of Overheating Risk in Asia